VCs’ Strange, Instinctual Need to Replace Founders

Venture capitalists exhibit some strange behaviors, but none is more bizarre than the near-inevitable scheming to remove a company’s founder-CEO. Odder still is that these plans are often hatched just as the company begins to really perform.

The process, instituted by a particular stripe of venture capitalist, represents the acme of “adult supervision” by the VC, a destroy-the-village-to-save-it moment of investor heroism. The show trial brings rote charges — the CEO is too autocratic, too visionary (crazy), late on monetization, late to exit, and far too young — with succession by a gray-haired realist as the inevitable penalty. The CEO, the VC reminds us, serves at the pleasure of the board. Sensible in theory, this strategy almost always destroys value in practice.

Let’s dispense with the case where the founder-CEO has tragic flaws, like corruption or wild incompetence. Those CEOs should be removed, although awkward questions linger about how so egregious a CEO could have slipped past investor diligence. We can also set aside the case where the founder and investors agree on a CEO for any number of reasons; those situations can also succeed (Schmidt, at Google, probably falls into this category). The more interesting case is where the founder-CEO is removed by investors in the name of progress. This case is surprisingly frequent: almost 40% of all CEOs are gone within three rounds of VC investment, usually in that way. Is this the right course?

In the most straightforward instance, VCs remove a CEO because his company underperforms. Doing so may be gratifying but it is irrelevant because young, failing companies can’t recruit external executive talent. Turning around GE or Yahoo may be prestigious and lucrative; at a minimum, big companies have the cash flow to ride out a turnaround. Start-ups are different — reforming a small company brings little glamour or money; it also brings fewer qualified candidates.

The weirder, more important instances come when a company is doing well. Frequently, VCs disagree with a key element of strategy, often how aggressively monetize the company at the expense of other growth. The downsides to doing so are several-fold. Founders have the moral authority to stick to a grand vision but also the flexibility for the sorts of radical experiments young companies must undertake but external candidates have difficulty imposing. If investors had been able to swap out Mark Zuckerberg in Facebook’s early history (considered the prudent course by many at the time), it’s not clear the company would have evolved into a world-bestriding giant. Equally, if VCs had succeeded in totally sidelining Page and Brin (again, an option considered at the time), Google’s brilliantly successful landing page would probably devolved into a tatty Times Square.

Founders also understand their companies in ways outsiders cannot and they possess an essential connection with their employees. CEOs brought in by VCs have much weaker intuition for the company and conflicting interests. Young companies depend on evangelism as a competitive advantage; carpetbaggers need years to establish credibility.

There’s a moral dimension, as well. In private equity — the world of Bain, and LBOs, and Gordon Gekko — replacing the CEO is part of the deal. The core of standard private equity is finding good ideas that are mismanaged by bad executives, so eliminating the CEO is often an essential part of the bargain and good for the company. In the case of venture-funded companies, which have little operating experience and untested ideas, the bargain is both the idea and the people, with the latter more important than the former. Why, then, destroy one asset to “improve” another?

Not every founder goes the distance, but it’s important that founder-led companies perform significantly better — a suggestive metric is that companies retaining their founders have produced substantially better returns than the S&P. There’s nothing surprising about this because thoughtful investors see no reason to interrupt a successful run and successful founders see no reason to leave their companies. Sometimes, the most adult supervision is no supervision at all.